Letter from Midwood Capital Management to the Independent Directors of Craft Brew Alliance, Inc.

BOSTON–(BUSINESS WIRE)–lt;a href=”https://twitter.com/search?q=%24BREW&src=ctag” target=”_blank”gt;$BREWlt;/agt;–Midwood Capital Management LLC (“Midwood”), a highly engaged shareholder
of Craft Brew Alliance, Inc. (“CBA” or the “Company”) (NASDAQ: BREW),
announced today that it has delivered a letter to the Independent
Directors of the Company’s Board highlighting the substantial gap
between the Company’s public market trading price and its intrinsic
value. Midwood encouraged the Board to recognize the difficulties CBA
faces to sustainably create shareholder value as an independent company
and to ultimately pursue a sale of the Company either to its strategic
partner and largest shareholder Anheuser-Busch InBev, or to a third
party.

Boston-based Midwood Capital Management is a private investment fund
founded by David Cohen. Midwood manages investment funds which focuses
on undervalued, niche-leading companies in the small-cap equity market
in the U.S.

The full text of the letter is below.

The Independent Members of the Board of Directors
c/o Audit
Committee Chair
Craft Brew Alliance, Inc.
929 N. Russell Street
Portland,
OR 97227
Attn: contains shareholder communications

To the Independent Directors of Craft Brew Alliance,

I am writing to introduce my firm, Midwood Capital Management LLC, as a
significant and increasingly concerned shareholder of Craft Brew
Alliance (“CBA”). Funds managed by Midwood currently own approximately
2.0% of the company’s outstanding primary shares.1 This
position makes us the company’s seventh largest shareholder (exclusive
of Anheuser-Busch InBev).2 We have owned shares in CBA since
mid-January 2017, and it has been a top five position for our firm for
the past two-plus years. Our interest in the company is simple and
consistent with that of all outside owners of the company: to see
shareholder value maximized.

At the outset of our investment back in January 2017, CBA represented a
special situation with several intriguing attributes, including:

  • A longstanding distribution alliance with the world’s largest brewer
    ABI
  • An uncommon situation whereby ABI was not only a commercial partner
    but also owned nearly one-third of the company and held two seats on
    the board of directors
  • A largely untapped international expansion opportunity
  • Ownership of the Kona brand whose compelling growth in an increasingly
    challenging beer market was being masked by flagging brands within the
    CBA portfolio
  • A set of then-recently signed (as of 8/23/2016) contracts between CBA
    and ABI that extended and expanded their commercial relationship and,
    most interestingly, established a framework under which ABI, if it so
    desired, could make a “Qualifying Offer” to acquire control of CBA

As an investment firm that seeks idiosyncratic situations whose value
realization would not necessarily be tied to moves in the broader
market, CBA was very exciting to us.

CBA also had – and continues to have – its challenges. Specifically, the
company’s consolidated revenue growth was poor3 as two major
brands – Widmer Brothers and Redhook – experienced significant volume
declines. Additionally, the company faced (and continues to face)
structural challenges in terms of its profitability due to its scale (as
well as business mix with the Pub segment) with gross and EBITDA margins
well below peers.

We can fast forward two years and take stock of the situation today.
Revenue growth has remained muted, growing at an average annual rate of
less than 1% over the past two years. Kona’s growth has remained
impressive, but Widmer and Redhook continue to drag on total revenue
given their volume declines. And operating income in 2018 was
essentially the same as operating income in 2014.

Management has entered 2019 with a new level of optimism regarding CBA’s
near-term growth potential with guidance for an increase in depletions
and shipments ranging from +5% to +8% for the year. To no one’s
surprise, this growth requires investment, and management has guided to
an increase in adjusted SG&A of approximately $10 million at the
midpoint or 15%.4 While we appreciate the company’s
willingness to invest behind higher growth, these investments are
material and the bottom line is that there is no assurance that the
company’s profitability will grow in 2019. The table below incorporates
management’s 2019 guidance to arrive at our EPS estimate for the year.
Even the high end of the guidance range, while yielding attractive EPS
growth on a percentage basis, would leave the company’s stock trading at
a very high P/E multiple in the mid-40’s. It’s also worth noting that
the consensus among sell-side analysts is that CBA’s EPS will actually
decrease in 2019.5

           
  Implied FY 2019     FY 2018  
Low       Mid       High Actual
Net Revenue 218.6 222.7 226.8 206.2
Gross Profit 75.4 79.1 82.8 68.3
– SG&A 70.0 72.0 74.0 62.6
= Operating Income 5.4 7.1 8.8 5.8
– Net Interest Expense 0.4 0.4 0.4 0.4
= Income Before Taxes 5.0 6.7 8.4 5.4
– Taxes 1.3 1.7 2.1 1.2
= Net Income (Loss) 3.8 5.0 6.3 4.2
/Shares Outstanding 19.6 19.6 19.6 19.6
= Diluted EPS (Midwood Est.) $0.19 $0.26 $0.32 $0.21
 

Midwood sees 2019 as a pivotal year. And presumably CBA’s leadership
also saw 2019 as a pivotal year when it crafted the multiple contracts
signed with ABI in August 2016. With the clock ticking on the August
2019 deadline for ABI to make a Qualifying Offer under the 2016
framework, we have a stock whose price has declined 8% since the
beginning of 2017.6

We acknowledge that CBA’s management has taken many actions to further
the objective of increasing shareholder value, and we applaud the team’s
efforts over the past several years. We have built a strong rapport with
Andy Thomas and value highly his leadership of the company. However, as
we think Andy would readily acknowledge, the craft beer segment faces
momentous challenges in a rapidly changing social lubricant industry. In
our opinion, despite Kona’s virtues as a brand and its solid growth, the
intrinsic value of this highly attractive asset will not be recognized
by the public market with CBA as a stand-alone
company
.

CBA lacks the margin structure and scale of its peers to grow sales,
profits, and cash flow consistently. Absent an ability to consistently
deliver this fundamental financial performance, the gap between price
and intrinsic value will not close in the public market. Shareholder
value will then only be maximized through a transaction in which another
entity determines what CBA is worth.

We would argue (based primarily on comparable industry transactions)
that the intrinsic value of Kona alone – excluding all other CBA brands
– should approach the current Qualifying Offer threshold of $24.50 per
share as illustrated in the table below

     
Standalone Kona Valuation
Low       Mid       High
EV/Barrel $900 $1,000 $1,100
x 2019 Est. Barrels 505,000
= Enterprise Value 455 505 556
+ Cash 1Q’2019 1.6 1.6 1.6
– Total Debt 1Q’2019 49.7 49.7 49.7
+ 2019 FCF [Implied Guidance] 2.5 2.5 2.5
= Equity Value 409 459 510
/ Shares Outstanding 19.6 19.6 19.6
= Value Per Share $21 $23 $26
Premium to BREW Market Price 36% 53% 70%
 

In terms of estimating private market value, we have as of May 9th yet
another relevant transaction in which The Boston Beer Company has
acquired Dogfish Head Brewery. At the announced transaction price of
$300 million, Boston Beer is paying $1,000 per barrel and 2.6x sales
based on estimated 2019 volume. In comparison, the public market is
valuing all of CBA at $435 per barrel and 1.5x forward sales – a
monumental discount in our minds.

CBA’s leadership expended a lot of time and energy in 2016 to codify the
relationship with ABI and provide a constructive framework for a
potential acquisition. With the current Qualifying Offer threshold of
$24.50 per share, we would argue that it would be difficult to find a
shareholder who would hold out for more than that price with the stock
currently trading at a far lower price.

Arguably, the market is significantly discounting the probability that
ABI will make an offer to buy the company. We know that CBA’s leadership
cannot control ABI’s willingness to execute on a Qualifying Offer. And
we also know that if such deliberations were occurring now, CBA would
not comment on them. Nonetheless, we believe CBA must find a buyer for
the company in any scenario. If not ABI, then someone else.

Looking at the company’s alternatives, we would sum up by saying:

  1. If ABI wishes to make a Qualifying Offer, we believe CBA’s board
    should absolutely accept it. And in our view the board should do
    whatever it can to facilitate ABI making an offer
  2. If ABI chooses not to make a Qualifying Offer, we believe there is
    considerable downside for the stock. In this event we believe the
    board should immediately announce a strategic alternatives process
    with a plan to sell the company. And while the board may be inclined
    to be reticent about such a path, we believe in this case that making
    an explicit announcement would be warranted

We have been engaged and committed shareholders in CBA for some time
now. We knew in early 2017 that the company did not craft its agreements
with ABI to only pursue a sale. However, with the combined effects of
the trends in craft beer industry and CBA’s inherent challenges to grow
revenue, profitability and cash flow, we strongly believe that the
company must seek a sale to maximize shareholder value.

Thank you very much for your consideration. We would be more than happy
to speak with any representative of the board to share more of our
perspective.

Sincerely,

David Cohen
Portfolio Manager and Managing Member
Midwood
Capital Management LLC

1 Midwood share count as of 5/10/2019. Total CBA outstanding
shares of 19,414,950 as of 5/02/2019 per the latest 10Q.
2
Source: Bloomberg LP.
3 Consolidated revenue grew 2.1%
and -0.8% in 2015 and 2016, respectively.
4 Management
guidance for 2019 updated as of 5/08/2019 including: depletions and
shipments each ranging between an increase of 5% to an increase of 8%;
average price increases of 1% to 2%; gross margin rate of 34.5% to
36.5%; Adjusted SG&A (excluding Kona settlement expense of $4.7 million)
ranging from $70 million to $74 million; effective tax rate of 25%.
5
Per Bloomberg as of 5/13/2019, 2019 EPS consensus among four sell-side
analysts is $0.115
6 Based on stock price of $15.53 as
of 5/10/2019.

Contacts

David Cohen
Portfolio Manager and Managing Member
Midwood
Capital Management LLC
617-912-4972